Miller/Howard Investments

Irreconcilable Differences: Saudi Arabia and US Shale Producers

April 15, 2016  |  Michael Roomberg, CFA, Portfolio Manager/Research Analyst

Michael Roomberg: Good day. My name is Michael Roomberg. I'm a portfolio manager and analyst at Miller Howard investments. Today we're going to follow up on a recent Miller Howard podcast entitled Crude Outlook in which we discussed the major variable that were monitored as the currently oversupplied crude markets come back into balance. To recap, we didn't provide a specific price forecast but what we did do is lay out why we think the current crude oil price is unsustainably low and that prices should move higher by year end. In short, natural global population growth and economic growth combined with declines in production from maturing wells will overwhelm what is now a much lower level of new oil well additions as the active recount has collapsed and will also outpace any production coming online from Iraq.

As long as there's no recession that reduces demand unexpectedly, the price would appear to have to go higher to incentivize more drilling activity or else we would fall into a supply shortage beginning in 2017. Again for more detail on this 9-12 month outlook you can click on our other recent podcast entitled Crude Outlook. In today's podcast we're going to shift focus specifically to the future of OPEC and what the emergence of shale means for the global balance of power in the crude oil markets. As everyone listening knows by now, the ability to extract economic quantities of oil and gas from shale is a technological revolution and a game changer. What does it really mean?

To help folks better understand we thought it might be helpful to frame this with some numbers. I'm going to be using rounded numbers for the purposes of simplicity as we go forward. As discussed in the previous podcast about 96 million barrels of oil will be produced around the world today and another 96 million barrels tomorrow and so on. About 1/3 of that or about 32 million barrels will come from the group of countries known as OPEC which means that about 2/3 of the worlds' supply or 64 million barrels will come from the countries and companies that are not party to OPEC. Within OPEC Saudi Arabia accounts for about 10 million barrels. About 1/3 of OPEC's production. Then in descending order in OPEC you have Iraq, Iran, the UAE, Kuwait, Venezuela, Nigeria, Cutter, and others. Outside of OPEC a simplified way to think about it is about 10 million barrels each come from the Russians and the United States. About 4 million each come from China and Canada and Brazil and Mexico account for about 3 million barrels each. All companies and countries that are party to OPEC.

Back to shale oil which really began getting underway at the beginning of 2011. At the beginning of '11, just five years ago, the US produced 5 million barrels a day of crude oil. At the peak in 2015, last year, the US produced 10 million barrels a day. All of that growth over that period was from Shale. The US, which had been declining in crude oil production for 25 years doubled that production in just 5. Obviously that's a tremendous growth spurt. It's even more remarkable when we consider that since 2011 the whole world increased its oil production by only 7 million barrels in total. 5 of the 7 million new barrels, or 70% of all new production on planet Earth came from US shale. Recall for much of that period from '11 to '15 oil prices were north of $100 a barrel. Producers were making great money and had no problem putting hundreds of billions of dollars into new wells trying to develop new supplies.

Yet collectively outside of the US they could only get 2 million barrels of incremental supply. In fact, most of that was actually from Iraq which was more of a recovery from the war than anything else. If we exclude Iraq and OPEC and US shale, 9 US non OPEC countries actually had declining aggregate production even though the spent plenty of money and had plenty of incentive to drill new wells. Oil is not easy to get out of the ground and shale is very unique. Today, all producers including US shale are very strapped for cash which means even less cash to maintain production levels meaning that there are not enough new wells being drilled to offset the natural decline from existing wells to maintain overall production levels, let alone to grown.

The US production figure we gave earlier of about 10 million barrels a day, again rounded, is now in decline. It's falling 100,000 barrels per month as well as mature. Meaning that if this rate continues the US alone would lose over a million barrels per day of production. The US industry has virtually shut down due to low prices. If prices rise again so will shale drilling. Drillers are obviously capitalists. The overall math is fairly well known. Most observers think that shale can keep production flat if prices rise to about $45 or $50 a barrel. Meaning at that level there are enough well locations that are attractive enough that it will incentivize enough drilling activity to offset the natural decline from existing wells.

Then the same observers apply to the same math think that if prices rise to about $60 supply could once again grow rapidly from shale because there are enough new drilling locations to grow production as it had been doing in the first half of the decade. It would then appear that there's sort of a long term structural barrier to prices persisting much about $60 in the future because of the supply response that shale provides. This is fantastic if you're in the business of owning and transporting crude oils in the United States. It's great if you're a gasoline consumer an airline buying jet fuel. It's a deadly threat if you're an OPEC member nation whose entire national economy is reliant upon crude oil and its prices.

I listed the major members of OPEC earlier. None has an agricultural heartland. None has a silicon valley. In most cases 80%–90% of their national revenue base is from the sale of crude oil. These countries have massive entitlement programs. Few if any income or real estate tax collections, they have totalitarian governments, and they have festering religious fundamentalism. While the cost of producing a barrel of oil in the sands of Saudi Arabia might be $10 a barrel, far below Shale, when one factors in the price needed to maintain social stability, that price is far higher. According to the IMF in Iraq that number is $68 a barrel. In Saudi Arabia it's $87. In Iran it's $107. In strategically located Yemen it's $157 a barrel to maintain financial health and social stability.

The only country that appears financially sustainable in a world where shale oil might cap oil prices at around $60 is in Kuwait which has a $49 break even because it has very few people relative to the size of its oil fields. These numbers will only grow worse over time for those countries as populations grow. Today the average mother in Iraq and Yemen has 4 children. In the wake of the price collapse OPEC countries have been burning through rainy day funds to support their spending. Saudi Arabia's fund is the largest but at the current crude prices the $750 billion Saudi Arabia sovereign fund will dwindle to zero by 2019. These countries only chance for remaining solvent if the present price continues is to dramatically cut government generous handouts. Given the fragility of their societies it's not unreasonable to wonder what happens when they do that.

Keep in mind when we evaluate today's crude oil market a tiny 2% oversupply balance is what has caused the world's oil prices to collapse over the past 82 months. Consider the potential impact on prices were we to see political unrest within one or more members of OPEC which disrupted supplies which account for 33% of the world’s oil supply collectively. To wrap up there are a number of factors that will be more important for the near term, the rest of 2016. Again for more info on that we suggest you visit our earlier podcast called Crude outlook. The purpose of this podcast was to highlight what we call irreconcilable differences between shale and the sustainability of OPEC countries over the long term.

The OPEC price war we think over the last 15 months was at least in part designed to try to ward off this future. There are likely to be many developments in this saga in the months and years to come but hopefully this recording helps frame those developments and helps reinforce long term math that suggests no matter the day to day new stories that shale will be an essential piece in the global oil equation over the next 3-5 years. Our first podcasts discussed the next one year. This one focused on the next 3-5 year period. Please be on the lookout for our next podcast that will touch on the period that's 5-10 years out. In that one we will discuss the impact of electric cars and the demand for crude oil over time. Thank you.


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